Like other nations, countries in Latin America are attempting to make their retirement systems more efficient and responsive to citizens’ needs. This is difficult in the best of times. But it is more problematic when countries have to deal with economic crises involving high inflation, slow growth, defaults on debt payments and currency devaluations – all of which have afflicted Latin America in recent years.


Knowledge at Wharton recently interviewed Olivia S. Mitchell, professor of insurance and risk management and head of Wharton’s Pension Research Council, to discuss the challenges facing retirement systems in Latin America. Mitchell is one of the world’s leading experts on pension schemes. She has served on President Bush’s Commission to Strengthen Social Security and on the Congressional Budget Office’s Advisory Board on Social Security Modeling. She also has been a consultant to the Asian Development Bank, the Japanese government’s Economic and Social Research Institute and the World Bank. In October, Mitchell appeared before the 23rd Brazilian Congress of Pension Funds in Sao Paolo, where she delivered a lecture titled “Options and Challenges for Pension Systems.”


Knowledge at Wharton: Broadly speaking, what are the issues facing pension systems in Latin America?


Mitchell: About two dozen Latin American countries have converted from the traditional defined-benefit system to the defined-contribution system in the last 20 years or so. The key questions are whether the plans are proving resilient, given capital market volatility, whether they’re providing benefits people need, and whether they’re generating savings. Overall, it’s a mixed picture: there have been some successes and some abject failures. We need to learn from both of those.


Knowledge at Wharton: What have been some of the successes?


Mitchell: Most people would look at the defined-contribution system put in place in 1981 by the Chilean government as quite successful. It replaced a retirement system that was in shambles. There were hundreds of different little pension funds in Chile, all of them bankrupt. They had to be shut down, since there really was no option to continue with the old system. Assets have grown quickly under the new system which seems to have returned decent, real rates of return over the last 20 years – some  years better than others, but decent. The pensions funds have become quite well diversified. Initially they were just invested in Chile and now they are invested more internationally.


Knowledge at Wharton: Do Chileans like the system?


Mitchell: It’s a relatively popular system but it’s not perfect. There are still concerns about coverage not being high enough. By no means is it a universal program: People in the agricultural sector and the self-employed tend not to participate in the system. There are still issues related to how much people can afford to contribute and whether they actively contribute. But, by and large, people see it as  a success story – certainly compared to what they were living with when Chile instituted the new plan. When you judge how plans like these are doing, you have to ask yourself, “If these plans hadn’t been there, what would have happened?” In many cases, things would have been quite wretched. The performance of the old plans was extremely poor, and people had very little confidence in them.


Knowledge at Wharton: What factors led to success in Chile?


Mitchell: Most people would attribute the Chilean success to a series of reforms that were happening in the economy as a whole during the 1980s. That is, they implemented banking reform and financial sector reform; they adopted new and improved accounting and reporting standards; and they restructured the insurance industry. Basically, there was a top-to-bottom refurbishment of the financial structure and the financial regulatory structure. That didn’t happen all at once, but took place throughout the 1980s into the early 1990s. The economy grew in response to all these changes. The pension system and the economy were interactive: The pension system benefited from the economic growth and the economy grew and there were more investment choices.


Knowledge at Wharton: Would an American citizen be familiar with a pension scheme like the one in Chile?


Mitchell: The Chilean pension system is quite different from what we have in the U.S. They don’t have a national Social Security program such as ours. Instead, they have a system where every worker must contribute 10% of his or her pay to a funded pension account, similar to a national 410(k) account. Chileans can choose which one of the pension plans they want to manage their money. There is competition between the pension plans but they are funded accounts. In that sense, it differs dramatically from the U.S. Social Security system, which is primarily pay-as-you-go and unfunded. But in the U.S., Social Security is just one part of the “three-pillar”  retirement system, with the other pillars being company-provided pensions and private savings.


In the U.S. if you put your money in a pension plan, the sponsoring company that you work for typically designs the plan and then tells you what your investment choices are. U.S. employers take on a tremendous responsibility in designing plans. In Chile, the nexus of the pension is not the employer; rather, the pension fund managers exist independently of employers. The structure is akin to TIAA-CREF, which is, in some sense, a pension fund that exists independently of the employers who pay into the plan on employees’ behalf. Chilean pension fund managers have to meet certain regulatory standards in order to enter the market. There is entry and there is exit, and they can compete against each other.


Knowledge at Wharton: Are there other differences?


Mitchell: Retirement systems in Latin America tend to be much broader in their provision of services than the U.S. Social Security system. When you talk about social security in most Latin American countries – and in Europe, too, for that matter – you also mean health care. Most retirement systems outside the U.S. provide national health insurance, disability benefits and unemployment insurance. The Mexican social security system delivers public health services to millions of people. That engages a whole different set of professionals – doctors, nurses and others – and involves building and managing medical facilities. There is a much greater set of challenges when a government institution is trying to meet so many different needs. 


Knowledge at Wharton: Give us an example of a country that has not done as well with pension reform.


Mitchell: One of the disasters would clearly be Argentina, which is facing economic challenges on every front, including pensions. When the economy went into a downward spiral, there was outright confiscation of pension assets by the government. Argentina’s pension scheme was set up much along the lines of the Chilean system. The pensions were supposed to hold a range of assets, they were supposed to be funded and there was supposed to be individual ownership of the funds. Yet, when push came to shove, the government essentially executed an “asset swap,” which meant that many people lost most of their pension assets.


Knowledge at Wharton: Is that money lost for good?


Mitchell: Nobody has offered to make them whole yet. This was a decision by the government to try to help bail out the rest of the economy, but the result was that the pension system was irretrievably harmed. It really gives pause to people who would argue, as I have, that funded pension accounts are a good way to go. It means you absolutely have to erect a “firewall” and keep it inviolate between the players in the system – the workers, the employees, and the government who might be tempted to use it for other ends.


Knowledge at Wharton: What lessons can be learned from Argentina?


Mitchell: One of the big challenges facing many of these funded systems has to do with where the assets are invested and how much regulatory control is exerted over their diversification. I’ve seen this in many different countries, including in Barbados where I worked a while back. Officials in Barbados were thinking about moving to a funded system, but the concern was that this country has a fixed exchange rate; consequently, some people were leery about having money depart their island. They also wanted the investments to stay at home to help their own country grow.


My argument has always been that when one sets up a pension system, the goal is to provide retirement security to the pension participants. Funding domestic building projects, or dams, or roads, is not really the purpose of a pension system. If a government or a private entity seeks to build a dam, fine, then raise the money for it, issue bonds. Be clear, be direct and be transparent about the way you think this ought to be done. All too often, governments have required that the pension money be directed solely to government bonds, thus supporting projects which may be worthwhile but which sometimes are not. If you don’t have a market mechanism choosing investment projects and pricing the risk associated with the projects, then it’s potentially going to be a debacle.


This highlights the point that many countries have wrestled with: What is the goal of a pension system? If one wants the system to take the interests of the participants into account, the assets should probably hold a portion of every company traded on world stock markets. The pension funds ought to be diversifying, they ought to be holding assets in many countries, not just their own. Mexico, for example, has just recently started to allow diversification out of its own government bonds, slowly, into other assets, but those assets are still domestic. Down the road, Mexico is proposing allowing more international diversification. It’s always a challenge and I understand the reasons why. But if I were designing a pension system, my goal would be to try to protect the participants.


Knowledge at Wharton: Does the step that Mexico is taking put it in the forefront of countries that are looking beyond the traditional way they have invested pension funds?


Mitchell: Mexico started its program, I believe, in 1999. As so often happens with developing countries, the government wasn’t confident enough about the valuation of corporate stocks and bonds to let the pension money of the masses of poor people be invested in the domestic capital markets. From a fiduciary, protective point of view, it seemed to make more sense to direct the money into government bonds. The issue is that, over time, more flexibility and more diversification should be permitted. The challenge many governments face is how to allow more diversification while still protecting the little investor. That is a huge concern brought into high relief by the market volatility and the poor market performance of the last two years.


Knowledge at Wharton: In a way, that’s comparable to the debate during the last couple of years in Washington over Social Security reform. The difference is the people in the U.S. still have the three-pillar system that you talked about, even though the stock market has taken a big hit.


Mitchell: The issue in the U.S., especially recently, has been, “How do we protect ourselves against scoundrels in the marketplace, the Enrons of the world?” My perspective is that nobody should be loading up his pension plan in one stock if that is all he has to retire on. A sensible retirement system ought to offer diversified, indexed, low-cost accounts that are inexpensive to administer. That’s the best protection you are going to get. 


Knowledge at Wharton: Let’s get back to Latin America. Can you give us other examples of how countries are faring with their pension funds?


Mitchell: I think one of the most interesting cases is Brazil. Of course, the great unknown is how the newly elected Labor Party will try to reform the retirement system. The Brazilian social security system faces enormous challenges because the public servants and the sector of the private work force that is covered by social security have been accustomed to quite generous benefits – benefits payable when a worker is still very young and benefits that are frequently indexed to the wage in the last job a worker held. If the person incumbent in that job gets a raise, then so, too, do all the retirees. This means the public social security piece of the Brazilian retirement system is extremely expensive. It has outstripped the tax revenue that is being levied to pay for it. It is very evident among the state and municipal workers in the different Brazilian states.


Three years ago, the Brazilian real was devalued, leading to great consternation in world capital markets. One of the reasons was that the individual states were so much in debt, because of their pension systems, that they had to borrow money from the federal government. But the federal government finally put the clamps on. That led to an internal financial crisis, which prompted a world financial crisis. Various governments have tried to negotiate social security reforms in 1997 and 1998. However, social security regulations in Brazil reside in the country’s constitution, and changing the constitution requires multiple votes and a supermajority. The result has been that they were unable to get necessary changes implemented. It appears that the annual cash deficit of the public sector pension is now in excess of 4% of GDP, and deficits of the private sector pension sector are also significant.  


Knowledge at Wharton: What role do companies play in Brazil’s pension system?


Mitchell: Corporations and other groups have tried to launch and foster the growth of company-sponsored pensions akin to those we have in the U.S. – defined-benefit plans in some cases, defined-contribution plans in other cases. But their growth has been hampered by uncertainty because of tax problems. If you want people to save in a funded-pension system, you need a clear-cut tax regime where you know what the tax consequences will be of contributing now and getting benefits later. Thus far, the Brazilian environment has been one where tax policy toward pensions has never been quite clear. This makes it extremely risky to set aside money in a pension fund because one is never sure exactly what one can get out of it. I think a couple of things are needed in Brazil. First, some serious reform of the social security system; and second, some clarification of the regulatory and tax structure for the corporate pension structure. Without that it is going to be very hard to move forward.


Knowledge at Wharton: What is your view of Lula [Luis Ignacio Lula da Silva, Brazil’s president elect]? Is he inclined to make the kind of changes necessary for reform?


Mitchell: One thing I find interesting is that the Labor Party has proposed an “integrated” social security system for all workers, public and private. That would be beneficial because this would eliminate the “special regimes” and “special benefits” with hard-to-understand regulations for different groups. The party has also come out in favor of funded voluntary pension plans. While both are reasonable, the devil is always in the details. As in most countries, the U.S. included, the public sector workers tend to be very organized, very vocal and very political, so changes in benefit formulas may be hard to implement.


Knowledge at Wharton:  Let’s discuss the future. Can you talk about the connection between economic problems that Latin countries have had and the health of their retirement systems?


Mitchell: It’s always a combination of domestic and international issues. For a long time Japan has been in the doldrums. Many European countries have been experiencing high unemployment and low growth. We’ve been in a pretty much low growth world or no growth world for, on and off, 10 years. The U.S. was somewhat protected from this initially, but now it appears that we are in the same boat as everybody else.


When the U.S. and Europe suffer a decrease in demand, along with unemployment and recession, there are immediate repercussions in Latin America. Surely many Latin countries have felt the spillover effects of reductions in imports of manufactured goods and raw materials in America – less wine being exported from Chile, fewer flowers from Colombia, all the things we now rely so heavily on Latin America to supply the rest of the world with. I wish I had a crystal ball to say when we are going to come out of this recession; in any event, the outlook remains uncertain for some time.


Knowledge at Wharton: How committed are Latin countries to U.S.-style free-market principles?


Mitchell: Every Latin American country is a little different. I do hear discussions of increasing populism now, increasing reluctance to rely on the market, increasing resistance to globalization. We are starting to see a growing set of voices saying, “Maybe the traditional go-go spirit of capitalism won’t sustain us in the long run.” You hear this a lot in Europe now, too. The priorities may start to change. Some people have said that Lula’s election in Brazil would result in a halt to further privatization of government-owned companies. That could change both the prospects for growth in the countries and how the financial markets are working, because growth requires new assets, new investments, new financing.


If an increasing percentage of the productive output of a country is owned by the government, this will put a damper on the ability of pension systems to buy and hold domestic assets. In order to make a successful pension system, it takes a lot of other support structures: a strong financial system, well-functioning capital markets, and a good insurance system to provide lifelong annuities. Each of these financial institutions  benefits from the other, in a cooperative sense. 


Knowledge at Wharton: In your view, which country has the best retirement system?


Mitchell: I don’t think there is a single system that will meet every country’s needs. Countries differ in their wealth and their ability to set up a program. Pension systems usually are a mix of insurance and redistribution – redistribution to provide benefits to people who have always been poor versus insurance to replace people’s earnings in old age. Every country finds a somewhat different balance between the insurance piece and the redistribution piece. That’s going to be partly a function of culture. In France, for example, every time I talk to someone about old-age benefits, they say, “We require solidarity.” That means they emphasize redistribution in old age. There is a minimum benefit for everybody and they try to make that minimum pretty high. Other countries, like Australia, focus more on the earnings-related portion. Workers save a percentage of their earnings, and in retirement they get back a benefit that is reflective of their pay. I don’t think there is a single model because every country is going to have its own politics, its own expectations, and its own culture.


I do believe that a good pension system is one where a government can credibly promise people, when they are young, that the money they are saving will be protected, it will be invested wisely, and it will be there when they are old. A good pension system is one that takes a long-term perspective, not short-term. People must be able to count on the fact that the money they set aside today will be there when they are 100 years old. All too often, countries, including the U.S., have taken a short-term perspective: “Can we get through this year? Can we get through the next three years?” Then people fail to see the hole they are digging for themselves five or 10 years out. One can design the balance of redistribution versus insurance anyway one wants, but the entire program must be viable in the long run. 


There is always room for improvement.  Ideally, pension systems would be transparent, so people understand that when they put their money in these plans, that it’s not going down a black hole. Workers need to feel a sense of ownership and should have some influence over the investment of the money. The concept of wealth accumulation is very appealing, especially compared to existing programs which face insolvency and are prone to mismanagement and sometimes worse.